Article excerpt

This may be our first epistemologically-driven depression. (Epistemology is the branch of philosophy that deals with the nature and limits of knowledge, with how we know what we think we know.) That is, a large role was played by the failure of the private and corporate actors to understand what they were doing. Most heads of ailing or deceased financial institutions did not comprehend the degree of risk and exposure entailed by the dealings of their underlings--and many investors, including municipalities and pension funds, bought financial instruments without understanding the risks involved. (1)

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There are two major competing narratives for the financial crisis. One narrative focuses on moral failure, in which the compensation structure for executives at financial institutions encouraged them to place their own and other firms at risk to reap short-term gains. (2) The other narrative focuses on cognitive failure, in which executives and regulators overestimated the risk-mitigating effects of quantitative modeling and financial engineering. It is important to sort out which of these narratives deserves more credence.

Those who emphasize moral failure have highlighted a number of distortions between private and social benefits, including: that executive pay at financial institutions is not tied to long term viability, (3) the "originate to distribute" model of mortgage financing gives the originator an incentive to make bad loans that are passed down the line in the system of structured financing of mortgage securities, (4) and rating agencies are overly generous in granting AAA and AA ratings because they were paid by the issuers of mortgage-related securities. (5)

Under the moral failure theory, the essential problem is the misalignment between the incentives of executives to maximize their own salaries and the long-term best interest of the financial firms they led. (6) In this narrative, regulators were either stifled by ideological faith in markets or hampered by organizational flaws--most notably, the alleged absence of anyone charged with monitoring systemic risk.

The other narrative is one of cognitive failure. Under this view, key individuals believed propositions that turned out to be untrue. Propositions that were falsely believed included: that a nationwide decline in housing prices, having not occurred since the Great Depression, was impossible; increased home ownership rates were a sign of economic health; the use of structured finance and credit derivatives had reduced risk to key financial institutions; monetary policy only needed to focus on overall economic performance, not on asset bubbles; banks were well capitalized; and quantitative risk models provided reliable information on the soundness of mortgage-backed securities and of the institutions holding such securities. (7) In hindsight, these propositions were wrong. Policymakers were caught up in the same cognitive environment as financial executives. Market mistakes went unchecked not because regulators lacked the will or the institutional structure with which to regulate, but because they shared with the financial executives the same illusions and false assumptions.

Under the narrative of moral failure, the financial crisis was like a fire started by delinquent teenagers, with the adults in charge not sufficiently inclined or positioned to exercise adequate supervision. The solution is thus to reorganize and reenergize the regulatory apparatus.

Under the narrative of cognitive failure, it is as if the authorities supplied the lighter fluid, matches, and newspapers used to start the fire. In particular, housing policy encouraged too many households to obtain homes with too little equity. Bank capital regulations steered banks away from traditional lending toward securitization. Moreover, these regulations encouraged the banks' use of ratings agencies and off-balance-sheet entities to minimize the capital held to back risky investments. …